Who’s on the Hook for Europe’s Losses, and for How Much?

What do you get when you mix politics with fundamental principles of economics and accounting? The answer is politics.

Both in the U.S. and in the euro zone, authorities seem willing to blame the weak economic recovery on weaknesses in bank, customer, and government balance sheets. However, they are not willing to come clean about what these balance sheets truly look like. The problem is not just that the assets of many systemically important banks are overvalued. The larger problem is that banks and governments are not made to account for the way in which, when important firms fall deeper and deeper into distress, implicit and explicit taxpayer guarantees absorb much of the markdowns that would otherwise have to occur.

In accounting parlance, a contra-liability is an item that is entered on a firm’s balance sheet when and to the extent that responsibility for servicing some of its debt falls on a third party. For banks, financial safety nets transform a block of unknown taxpayers into just such a third party. The unacknowledged value of taxpayer guarantees are, economically, an unbooked contra-liability of the modern commercial and investment bank and an unbooked, and uncertainly dated, liability of the taxpaying households and firms. Those taxpayers are the ones that troubled governments are likely to saddle with the final bill for the bailout support that pressure-group politics currently and surreptitiously dictates.

Taxpayers’ side of the bailout is a huge drag on the world economy. This is because, with each further delay in resolving the insolvency of zombie banks, rational taxpayers (including solvent banks) have to cut their spending and investment activity to set aside more and more of their wealth in an implicit or explicit precautionary reserve that is large enough to cover their surging tax exposure.

This is why it is disgraceful for spokespersons for JPMorgan Chase (JPM) to claim that its suffering a several billion dollar loss in derivatives bets in London markets had no effect on U.S. taxpayers. This claim mendaciously ignores the way that observing so massive a failure in bank and regulatory risk management has increased taxpayers’ estimates of their side of the taxpayer put and fanned taxpayer fears about other hard-to-observe forms of TBTF risk-taking.

Not having to account for taxpayers’ equity stake in too-big-to-fail institutions generated by regulatory delay and forbearance undermines political accountability and limits deceiving management teams’ exposure to fraud claims.

In the European Union, intense uncertainty exists about the size of the liabilities and the prospective identity of the particular creditors, taxpayers, and range of countries that will finally be made to cover the shortages of its insolvent banks and sovereign nations. The inability of outside parties to size the insolvencies accurately fans taxpayer uncertainty and makes ordinary citizens’ precautionary reserve all the larger in the aggregate.

Counterproductive delays in resolving the insolvency of large financial firms are the rule, rather than the exception. In the European Union today, laying more of the bailout burden on another country’s taxpayers is the primary goal both of those pushing for a pan-European solution and those who are resisting their efforts. Whether we are talking about an expanded bank recapitalization fund, a joint deposit-insurance authority, or a banking union or fiscal union, the issue is the same: Who will pay the bill and how large will it get before it is finally presented?

Seemingly endless negotiations over this issue support gambling for a hard-to-foresee economic recovery among the regulatory community and a go-for-broke casino mentality in the undercapitalized financial community. In the meantime, the job of the European Central Bank has become to issue increasingly poorly collateralized loans to increasingly poorly capitalized and insolvent banks.

In my opinion, this process is turning the ECB into the biggest and most dangerous zombie of them all.

One Response to "Who’s on the Hook for Europe’s Losses, and for How Much?"

Great story. I have fairly similar views. Not just about who will foot the bill, but also about possibility of top leaders in business and finance made to stand trial (just like the grand jury hearings for Goldman,Citi etc after the 2008 crisis). Pasting below the story which I did a few weeks back.

Can Greece take down the world?
¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯
All of the current discussion about Greece causing a Doomsday is starting to sound more and more ridiculous (which is the funny part). Nonetheless, the underlying factors could be a far more serious issue. Here's why:

Funny aspect # 1
¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯

The country of Greece is comprised of less than 0.5% of Global GDP! It is pretty understandable that when the U.S. sneezes, the world catches a cold- after all, the U.S. is nearly 30% of the world’s GDP. But can Greece cause a global slowdown – I really doubt so.

Funny aspect # 2
¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯

There is a report from the IIF that was prepared to scare some of the hesitant lenders into signing off on the country’s bailout package. Through a series of 'well reasoned' arguments, the report discusses a global slowdown due to Greece’s default. Now, how all of this would be achieved by such a minuscule economy like Greece – which is less than 0.5% of the global GDP- has truly made the IIF report a hilarious read.

Funny aspect # 3
¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯

In the debt deal of February 2012, private creditors were quoted to have forgiven more than half of the Euro 200 Bn of outstanding. If forgiving more than 50% of a loan is a 'deal', then what in the world does a default mean?

Funny aspect # 4
¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯

Which brings us to the next aspect of our humorous stroll- If this 50% 'forgiveness' didn't cause any real blip on the global economy, will the default of remaining 50% cause a global slowdown?

Of course, if this were to really happen, then the economists would surely begin to discuss CDO losses and the contagion effect. This leads us onto the following serious issues:

Serious issue # 1
¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯

Several banks and institutions will certainly go down, and countless jobs will be lost. What will become of the bankers who are going to be held responsible for writing those CDO's on Greece? More importantly, what about the politicians who are going to lose power? Let’s think of them for a moment. I would think that in such a scenario, countless big-wigs in banking & finance industry would no doubt be joining the hall of shame along with Alan Greenspan, Dick Fuld and many others. Some of these people could likely get prosecuted, and possibly even join Maddoff’s ranks as well.

Serious issue # 2
¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯

Every economic crisis, including the most recent one beginning in 2008, clearly portrayed the lack of integrity and competency in the so called business leaders who are supposed to be examples of these very qualities. Furthermore, after every crisis, skeletons started to tumble out of the closet. Here are a few examples; they almost sound funny

Some of the rating agencies were later stated as saying that they had made mistakes in their excel spreadsheets and models, resulting in more than a few incorrect evaluations. Imagine that- a world crisis caused by a few excel mistakes; and the men who are responsible for those mistakes are supposed to be CPA's , CFA's, PhD's and MBA's. This calls not only calls into question the very competency of these professionals, but more so the leadership within the company.
Only the relatively junior level executives who created those CDO's knew what they were actually comprised of, yet they did not have the experience to understand the risks and future implications. Furthermore, the senior leaders- who had the experience to understand the risks- didn't completely understand how the CDO's were structured, so they preferred to count their bonuses, rather than to show their ignorance.
In conclusion, the question to ask is- can a minuscule economy with less than 0.5% of the global GDP cause a Doomsday effect, or are the business and political leaders really afraid of something else?